3 Warnings Before You Play With Inverse ETFs Like DUST

by James Brumley | October 3, 2013 9:13 am

3 Warnings Before You Play With Inverse ETFs Like DUST

To say the last month has been a poor one for gold — and the exchange-traded funds that correlate with it — would be an understatement. Since Aug. 28, the SPDR Gold Shares (GLD[1]) has fallen back more than 7%. As big as that plunge was, it’s much less dramatic than the 26% pullback gold and gold ETFs have doled out since last October.

It gets even worse for gold mining stocks and gold mining exchange-traded funds. The Market Vectors Gold Miners ETF (GDX[2]) is off 20% just since the end of last month, and has given up a stunning 55% of its value over the past 12 months.

While most gold permabulls, a little shell-shocked, simply watched the implosion from the sidelines, a few opportunistic traders smartly jumped into the Direxion Daily Gold Miners Bear 3X Shares (DUST[3]) … an exchange-traded fund that moves in the opposite direction of the Market Vectors Gold Miners ETF, only three times as far in that direction.

Said another way: If gold mining stocks pull back to the tune of 10%, the Direxion Gold Miners Bear 3X fund theoretically will rally 30%.

Source: TradeStation

The appeal of a fund like DUST is obvious. Not only do you get some serious leverage on any move that gold or gold miners make, but these funds are accessible to anyone, in any type of account.

In other words, to take direct advantage of a dip in the value of the SPDR Gold Shares or the Market Vectors Gold Miners ETF, an investor would need a margin account that’s approved for shorting stocks. DUST, conversely, gains in value for owners with a long position in the fund when gold miner stocks lose value. As such, this leveraged inverse fund can — for better or worse — be purchased by anyone with a brokerage account, or even a retirement account.

And it’s that last detail that really forces anyone mulling a position in the inverse fund to ask themselves a critical question: Does being able to do something mean you should do it?

No.

Seriously, They’re Not for Everyone

See, while the Direxion Daily Gold Miners Bear 3X Shares might move up three times as quickly as gold mining stocks fall, they also fall three times as quickly when gold miners rally. Translation: You have to be right about your call, or you have to be very quick to make an exit when it’s clear you’re wrong.

Most anyone who has traded or is considering a trade in any inverse leveraged ETF probably knows that. But, in the heat of the moment, it’s amazingly easy to forget both of those realities. It happens to even the most seasoned and experienced of traders; everyone is vulnerable to buying into the “it has to reverse soon” fallacy.

That’s not to say you in particular shouldn’t dabble in these riskier investment vehicles. But, for what it’s worth, there are plenty of traders and investors who have been in a DUST position, but shouldn’t have been. It is possible you’re one of them.

So, if you need someone to be explicitly clear about it — and put it in writing — here you go:

The Direxion Gold Miners Bear 3X fund and other inverse leveraged funds don’t belong in any retirement account. That’s not to say they can’t do well for you in an IRA, but assuming a retirement account is money you’ll actually need for retirement, the risk of a leveraged inverse gold fund in an IRA just isn’t worth it.

The Direxion Gold Miners Bear 3X shares shouldn’t be owned without a pre-determined stop-loss in place at all times. As was noted above, in the heat of the moment, discretionary discipline can get thrown right out the window. That’s when trouble begins. And with these ETFs moving three times as fast as their underlying index, it takes very little for an adverse move to cause trading anxiety to skyrocket, which is when serious errors in judgment start to crop up.

The Direxion Gold Miners Bear 3X fund isn’t a core piece of any serious portfolio, and certainly shouldn’t be a portfolio’s biggest (or only) holding. This probably isn’t a problem for most everybody, but undoubtedly there are a few people out there who would not only bet the farm on such a fund, but would remain in that bet for years, calling their stubbornness “commitment.” This ETF is largely designed to be a short-term hedge. Nothing more.

Bottom line? The next time you find yourself interested in getting into a Direxion Gold Miners Bear position, put in writing (1) exactly why now’s the right time to buy it*, (2) what your target price is, and (3) where you’re going to bail out if things don’t go well.

If you can do that, you’re miles ahead of most of the other people dabbling in this unique fund.

* The “it’s going higher” argument isn’t enough. What historical precedent do you have that supports a new entry now?

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.